Table of contents
- What is geopolitics?
- A brief history of geopolitics impact on forex
- Top geopolitical triggers of forex volatility
- Assessing geopolitical risks and forex impacts
- Did you know?
- Strategies for trading geopolitical events in forex
- Geopolitical events case studies
- How can ThinkMarkets help me stay informed about crucial geopolitical events to enhance my trading decisions?
- Conclusion
For forex traders, monitoring geopolitical risks is as important as analysing economic data and conducting market analysis. Geopolitics plays a vital role in the currency markets through significant events such as political instability, sanctions, trade disputes, and wars, which trigger moments of volatility. Given the hyper-connected nature of global markets, you cannot ignore geopolitics in the current forex market.
This article intends to give you a detailed explanation of the impact of geopolitical events on currencies. We will cover the basics of geopolitics, examine key historical examples, and outline strategies for analysing risks. Additionally, we shall identify the top geopolitical drivers of forex volatility and explain how to trade geopolitical catalysts. To illustrate real-world trading dynamics and forex reactions, we will also analyse several case studies of recent significant geopolitical events, such as the US-China trade war and Russia’s invasion of Ukraine.
Whether you’re a veteran forex trader or a beginner just getting started, this article will equip you with the skills to navigate the geopolitical crosscurrents continually roiling the currency market.
What is geopolitics?
Geopolitics in forex trading refers to how international political events and developments affect currency exchange rates and the forex market. The concept of geopolitics covers various political activities, including conflicts, treaties, elections, and changes in government policies, which can significantly impact a country’s economic stability and prospects. Forex traders monitor geopolitical events closely because they can trigger significant currency-value volatility.
According to the European Commission, geopolitics examines how countries “leverage their geographic advantages, positions, and prospective trajectories to influence regional and global dynamics in cooperation or competition with other nations.” While geopolitics remains rooted in physical geography, it has steadily evolved to incorporate a broader range of cultural, social, technological, and economic elements that shape the power dynamics between states.
Geopolitics is part of fundamental analysis and can play a critical role in your trading decisions if you understand how geopolitical events affect market dynamics. Fundamental analysis can help you figure out the interconnections between geopolitical developments and market movements, creating a robust foundation for making better trading decisions.
A brief history of geopolitics impact on forex
Throughout history, geopolitics has significantly impacted the valuation of currencies. For example, in the late 16th century, the Dutch fought for their independence from their Spanish rulers, leading to significant swings in the values of European currencies.
Next, the Napoleonic Wars of the early 1800s also profoundly disrupted European trade flows and politics, impacting the exchange rates between currencies such as the French franc, the Sterling pound, and the Spanish dollar. Major battles like Britain’s victory against France in the Battle of Waterloo in 1815 impacted the global forex markets.
In the early 20th century, World War I marked the end of the pound sterling’s multi-century reign as the leading global reserve currency. As the British Empire began to decline, the start of WWI sparked a capital flight from pounds to the security of the US dollar and other currencies, which WWII further accelerated. By the end of the two world wars, the dollar had surpassed the sterling pound as the world’s predominant reserve currency, demonstrating how geopolitics can significantly affect the forex markets.
The connection between geopolitics and the forex markets deepened further in the 1970s as the modern-day forex market emerged, coinciding with the 1973 Arab-Israeli War and the Arab oil embargo. These events sent shockwaves through forex markets as supply shocks and soaring oil prices jolted currencies worldwide.
The 1979 Iranian Revolution and resulting hostage crisis, just six years after the Yom Kippur War, provided another instructive example of how geopolitics breeds forex volatility by altering trade flows, inflation, haven flows, and market psychology.
While the Cold War featured fewer direct military conflicts than in previous decades, the perpetual geopolitical pressure between the USSR and the U.S. injected lasting uncertainty into markets. As a new era of globalization began, the collapse of the Berlin Wall in 1989 and the Soviet Union two years later shook forex markets once more.
Top geopolitical triggers of forex volatility
Given geopolitics’ complex and multifaceted nature, any event with far-reaching trade, economic, or political ramifications for leading economies can influence the currency market. Some geopolitical events tend to be incredibly potent drivers of forex volatility over short- and long-term timeframes. Let’s look at some of the most impactful geopolitical catalysts for currencies.
Wars and military conflicts
Based on historical events, the outbreak of war between nation-states typically stuns the forex markets. The currencies of the warring parties usually plunge at the start of the war amid fears of economic devastation as investors flee to safe haven currencies such as the Swiss franc, U.S. dollar, and Japanese yen. However, if the war drags on for months or years, its effects on the forex markets largely depend on domestic political stability, trade disruptions, central bank policies, and inflation shocks.
Political turmoil and civil unrest
Political instability within a country, whether stemming from government transitions, civil wars, coups, uprisings, or other root causes, tends to punish that nation’s currency through capital flight and economic uncertainty. General strikes, protests, and civil unrest paralyse economic activity or undermine a country’s political institutions and leadership, hence roiling domestic exchange rates.
Persistent turmoil may eventually translate into more profound structural forex implications if a nation’s economic prospects and trajectory are fundamentally affected. Geopolitical impacts from domestic political crises are not confined to the affected country. For example, the fall of the Soviet Union in the early 1990s and the economic and social turmoil that ensued impacted global trade flows, migration patterns, investment flows, and forex alignments in consequential ways.
Terrorist activities
While they are more localised in scope than open warfare or civil unrest, terrorist attacks and other unanticipated geopolitical shocks have proven capable of abruptly disrupting forex sentiment and capital flows. After events like the 9/11 attacks on the U.S., deadly bombings in European capitals, and hostage crises or hijackings, safe haven currencies routinely rally. In contrast, those involved in the attacks sink. Terrorist strikes that disrupt key trade hubs, mass transit systems, or global supply chains tend to trigger outsized forex volatility.
Trade policies and disputes
Protracted trade disputes between major economic powers, tit-for-tat tariff battles, or shifts in free trade agreements can significantly impact the forex markets by altering trade balances, inflation dynamics, and economic growth trajectories.
The currencies of nations involved in trade wars tend to depreciate against trading partners who do not have the same disputes, as investors position themselves in anticipation of a fall in export competitiveness and slower GDP growth.
The spillover effects of significant trade frictions can also affect currencies that are not directly involved in the trade wars but are closely linked to either trade partners through supply chains or financial ties.
Sanctions and barriers to international commerce
Both unilateral sanctions and multilateral embargoes or restrictions imposed by bodies like the UN Security Council unambiguously escalate geopolitical tensions. Disrupting the flow of goods, capital, and financial transactions between nations can damage domestic currencies.
In extreme cases, like the Western sanctions on Russia following its invasion of Ukraine in 2022, comprehensive embargoes that “de-platform” a country from global financial networks and markets inflict supply/demand shocks destabilising broader forex market dynamics and functions.
Relations between major economic powers
Given the might of economic superpowers like the U.S. and China, geopolitical frictions between them reverberate across the global currency markets. Major political, trade, or economic shifts between these titans can alter exchange rate regimes, investment flows, trade volumes, and growth expectations in ways that remap forex valuations worldwide.
As the world’s two largest economies, the evolving dynamic between the U.S. and China and its fallout on forex is arguably the prime geopolitical focus for investors. Volatility often spikes around flashpoints like China’s economic dealings with Taiwan, North Korean nuclear negotiations, and tensions over the South China Sea.
Shifting fragilities in the global financial system
Geopolitics underpins the structure of the global financial system despite economic forces being the primary drivers of the forex markets. Aspects such as the realignment of reserve currencies and challenges to pillar currencies such as the U.S. dollar or the IMF’s status could disrupt payment networks, as could threats of cyberattacks or digital warfare against financial infrastructure, all emanating from geopolitics.
Any events that could shake investor confidence in the longstanding forex market functions or frameworks could create extra uncertainty and volatility. Transitions and fragmentations within the global financial ecosystem can profoundly redistribute capital flows, economic trajectories, and forex valuations across regions and nations.
Assessing geopolitical risks and forex impacts
Given the vast number of geopolitical events that occur over time, not all have a massive effect on the currency exchange rate. As a trader or investor, you should develop your skills in identifying the events that can impact currency markets and those that are mere noise.
To objectively analyse geopolitical events, you must look at various factors to determine whether a geopolitical event will significantly impact a specific currency. These factors include:
- Financial and economic relevance for leading economies
- Potential disruption of trade flows and global supply chains
- Likelihood and magnitude of inflation or deflation shocks
- Market psychology shifts and safe haven demand ramifications
- Potential for triggering policy actions by central banks and governments
- Broader impacts on economic growth expectations, yield curves and interest rate policies
- Implications for the status of reserve currencies and capital flows
Prudent forex traders also weigh the knock-on effects and second-order shocks that could be triggered, including the outbreak of domestic disturbances, spikes in energy costs, or threats to critical infrastructure and cyber networks.
While traders must avoid overreacting to geopolitical clickbait, truly impactful events like the 1970s Arab oil embargo, the 9/11 attacks, and the Russian invasion of Ukraine demonstrate geopolitics’ ability to unsettle longstanding forex equilibriums and challenge trading assumptions. An essential risk management skill is effectively assessing which geopolitical sparks are likely to ignite forex firestorms.
Did you know?
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Strategies for trading geopolitical events in forex
Given their complex, unpredictable, and fast-moving nature, geopolitical events often require specialised trading tactics in currency markets. Rather than relying solely on automated signals or rigid rules-based systems, forex traders typically implement discretionary, actively managed strategies around significant geopolitical developments.
For many traders, one of the most famous plays during geopolitical flare-ups is buying safe haven currencies like the U.S. dollar, Swiss franc, and Japanese yen. These currencies tend to surge amid geopolitical turmoil as institutional and individual investors seek shelter from volatility.
Capital flight out of affected regions creates imbalances that appreciate safe-haven currencies against most of their peers. The yen is extremely sensitive to safe-haven flows, with the USD/JPY pair often encountering outsized swings during major geopolitical episodes as macro funds and other large players pile into (or liquidate) their yen exposure.
Beyond the safe haven trade, forex traders may adjust positioning and leverage around geopolitical events by using tactics like:
- Hedging exposure through forex options.
- Taking profits and reducing overall position sizes.
- Scaling into new trades gradually as situations evolve.
- Increasing trailing stops to protect unrealised gains.
- Implementing contingency plans for worst-case scenarios.
- Managing concentrated currency risk exposure in portfolios.
Rather than attempting to mindlessly “fade” the volatility, more active traders often aim to capitalise on geopolitical developments by scaling into positions following initial outsized moves and trading swings within the broader geopolitical-driven trend.
Underscoring all these approaches is imperative for forex traders to tighten risk management and maintain trading discipline around geopolitical upheavals. Wide stop-loss orders may be required to deal with increased intraday gyrations while awaiting resolution. Patience is vital, as geopolitical shocks typically generate multiple aftershocks before situations stabilise.
Some advanced forex traders craft intricate, event-driven trading strategies using options, spreads and other complex strategies to maximise risk and reward around geopolitical catalysts. Meanwhile, passive investors focused more on longer-term horizons often maintain strategic currency exposure while riding out geopolitical storms.
Adaptable forex traders thrive in volatile geopolitical times, adjusting risk, monitoring news, and responding swiftly to shifting fundamentals.
Geopolitical events case studies
The U.S.-China trade war
The trade war between the United States and China from 2018 to 2020 offers another compelling case study for understanding how geopolitical tensions can impact foreign exchange markets. This prolonged conflict significantly influenced the value of the Chinese yuan (CNY) and the US dollar (USD).
Pre-trade war landscape:
Before the escalation of tensions, the USD and CNY maintained a relatively stable relationship, with the USD/CNY exchange rate hovering around 6.8 RMB per USD. This stability primarily reflected the strong economic ties between the two countries, with China being a major importer of US goods and a significant holder of US Treasury bonds.
The escalation of tensions:
In 2018, the US imposed tariffs on significant Chinese imports, accusing China of unfair trade practices. China retaliated with counter-tariffs on US goods. This tit-for-tat exchange created a climate of uncertainty and disrupted global supply chains.
Impact on currencies:
The trade war impacted the USD and CNY in contrasting ways:
- USD: The USD initially benefited from the flight-to-safety phenomenon. Investors seeking safer assets during times of uncertainty often favour the USD due to its perceived stability. This led to a temporary strengthening of the USD against several currencies, including the CNY.
- CNY: The Chinese government actively intervened in the forex market to curb the yuan’s depreciation. This included measures like selling US Treasury bonds and raising interest rates. However, the yuan still experienced some weakening against the USD, with the exchange rate reaching above 7 RMB per USD at its peak.
Limited long-term impact:
Despite the initial volatility, the trade war’s long-term impact on the exchange rate was moderately less significant than some initial predictions. The USD/CNY rate eventually settled within a range close to pre-trade-war levels, reflecting:
- The global economy’s interconnectedness meant both countries suffered economic losses due to the trade war. This pressure ultimately led to a partial truce and a de-escalation of tensions.
- The Chinese government’s efforts to stabilise the Yuan proved relatively effective, preventing dramatic depreciation.
Key takeaways
The U.S.-China trade war case study highlights several key takeaways:
- Trade conflicts can create uncertainty and impact foreign exchange markets.
- Investors may seek “safe haven” currencies like the USD during periods of tension.
- Numerous factors, such as currency management techniques and global economic interdependence, can lessen the long-term impact of geopolitical events on exchange rates.
It’s important to consider that the trade war was just one factor influencing the USD and CNY during this period. However, this case study serves as a valuable illustration of how geopolitical events can affect currency prices and the complex dynamics of the forex market.
Brexit
The UK’s vote to exit the EU, commonly known as Brexit, is a compelling case study for understanding the significant impact of geopolitical events on foreign exchange rates. This event triggered a series of economic and political uncertainties that significantly impacted the value of the British Pound (GBP) against other major currencies like the US Dollar (USD) and the Euro (EUR).
Pre-Brexit landscape:
Before the 2016 Brexit referendum, the GBP enjoyed a relatively stable position, trading around 1.40 USD and 1.25 EUR. This stability was primarily attributed to the UK’s strong economic ties and close integration with the EU, which offered benefits like the free movement of goods and services.
The impact of the referendum
After a narrow majority voted to exit the EU, the referendum’s outcome triggered immediate uncertainty and market volatility. Investors became apprehensive about the future of the UK’s trade relationship with the EU, potential economic disruptions, and the country’s overall political stability, resulting in a sharp decline in the value of the GBP.
- The GBP/USD exchange rate fell by over 10% in a day, reaching its lowest level in over 30 years.
- The GBP/EUR exchange rate also experienced a significant depreciation, falling by around 7%.
Post-Brexit negotiations and continuing volatility
The years following the referendum saw long-lasting negotiations conducted by the UK and the EU over the conditions of their separation. This period continued to be characterised by uncertainty and risk aversion, leading to further fluctuations in the GBP.
- The GBP/USD exchange rate remained volatile, oscillating between 1.20 and 1.40 for several years.
- The GBP/EUR exchange rate also experienced similar fluctuations, trading from 1.05 to 1.20.
The long-term impact
Although the UK officially left the EU in January 2020, the full impact of Brexit on the GBP and the broader British economy is still unfolding.
As of March 2024, the GBP/USD exchange rate remains approximately 10% lower than its pre-referendum level, and the GBP/EUR exchange rate is down by around 15%.
Key takeaways
The Brexit case study highlights several key takeaways regarding the impact of geopolitics on foreign exchange:
- Geopolitical events can trigger significant market uncertainty and volatility.
- Investor sentiment is critical in determining the direction of currency movements.
- The long-term consequences of such events can take years to materialise fully.
It is important to note that Brexit is a complex event with multifaceted implications, and its impact on the GBP is not solely attributable to geopolitical factors. However, this case study is a valuable illustration of how geopolitical events can significantly influence currency valuations and the broader economic landscape.
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Conclusion
The article demonstrates the complex relationship between global political developments and their impact on currency trading. It emphasises how geopolitical events, ranging from wars and political upheaval to trade spats and sanctions, significantly influence forex market volatility. It emphasises the clear link between global political instability and currency value fluctuations. The article cites historical and contemporary occurrences, such as trade disputes between the United States and China and Britain’s withdrawal from the European Union.
